In this land of the 10-year bull market lives a Canadian investor who believes he can turn his $6,000 bet into something like $300,000. He believes he’s found products (leveraged and inverse exchange-traded funds) that will not only protect his portfolio but also allow him to strike big when things turn ugly. Spoiler: we don’t think it’s very likely. His market outlook is not unfounded, but these products are not made to deliver anything like the Big Short.
About 18 months ago, individual investor Jeremy Kher injected about 5% of his portfolio into Horizons’ BetaPro S&P 500 VIX Short-Term Futures ETF (HUV) at around $6 a unit. Since then, HUV has declined to approximately $3, causing his position to register a 50% loss. “I don’t care,” he shoots, “and I even plan to buy more of it. I also plan to diversify into other ETFs, like HSD (BetaPro S&P 500 -2x Daily Bear ETF) and HIX (BetaPro S&P/TSX 60 Daily Inverse ETF). Instead of putting money in cigarettes, I have this ETF. It’s money in the bank for very bad days ahead.”
At face value, his expectations are sound. In 2011, in the wake of the financial crisis, and shortly after being launched at the end of 2010, HUV reached a peak of $2,240, then slowly and inexorably wound down to its present level. So Kher logically expects it to shoot back up somewhere in the range of its peak, even beyond. In the process, his little loss of 50% will be buried over by gains in the 1000% range. His present $3,000 could very well become $300,000, maybe even $3 million.
However, Mark Noble, senior vice president of ETF strategy at Horizons ETFs, disagrees. “Kher’s expectations are disproportionate and show a number of misunderstandings,” he says.
Incompatible
You could perhaps blame some of this misunderstanding on the online charts. Charts report peak prices of $2,240 in 2011 for HUV. What they don’t show is that as markets were rebounding after the financial crisis, HUV and the 2X bear ETFs dropped dramatically, and there reached a point where the price was so low, in penny stock range, that Horizons chose to consolidate the price back to a more attractive level – like a reverse split.
Noble explains that HUV was “consolidated by a factor of four in 2013 and by a factor of 20 in 2015.” Run that calculation in reverse and you’ll see why the past performance looks so sky-high. “The essential take away,” Noble says, “is that, when you buy a unit of HUV today, it’s the equivalent of buying about 120 units in 2010. Hoping to see HUV vault back to anywhere near $2,240 is not only extremely unlikely, it is impossible.”
Kher must tone down his expectations. Considerably.
That is not to say that HUV and many others of Horizons’ BetaPro ETFs can’t present attractive rewards. “There are days where HUV can spike by 40%,” Noble notes. But the downside can be just as formidable and the next day HUV can plunge by an equivalent 40%.
“HUV is high reward, but high risk also,” Noble points out. The same can be said of Horizons’ BetaPro lineup of 25 leveraged ETFs, the large majority of them 2-times leveraged. Even if it is not leveraged, which makes it an exception, HUV presents itself as the riskiest of Horizons’ Betapro ETFs because it is linked to the VIX index. Often nicknamed “the fear gauge”, this index measures expectations of volatility in the market – making it even more volatile than the markets themselves.
Buyer beware: Short-term use only
All ETF specialists consider that the BetaPro products have to be used as short-term instruments to protect positions in a portfolio or to take advantage of special situations. “They can be appropriate to speculate in the short term, but I would avoid them as soon as the holding position extends beyond a few days,” says Raymond Kerzhéro, director of research at PWL Capital. Their behaviour is too unpredictable on the longer term because of the daily reset on each individual ETF.”
This “daily reset” is a key component of the BetaPro ETFs. They were designed, explains Noble, “to allow any investor to have a leveraged exposure without using margin, which makes your risk unlimited: you can lose more than your initial investment. To avoid that, these ETFs reset their exposure on a daily basis. The performance can look much greater, or lesser, than what you would expect from your initial investment.”
In markets that have a clear direction, up or down, the net effect of “reset” is quite intuitive, though it can still hold surprises. For example, in a 5-day up-trend where the S&P 500 would increase by 10% every day, total return for the index would be 136%. However, an investment of $1,000 in HSU (2X daily Bull ETF) would land at $2488, or 416% higher, much more than a straight doubling of 136%.
1+1-1 = -1.5
However, in a highly volatile market in which the direction is not clear, results can be baffling. Take a cycle of 25 days in which the index starts at 100 and, after haphazardly registering gains of 5% or 10% some days, then equivalent losses other days, comes back to 100. With a regular stock, an investor’s original position of $1,000 would come back to $1,000. But with HSU, his net return would be -19%, with HSD, it would be -40.7%.
How’s that? Because of the reset mechanism. Starting at $1,000 on day one, after a gain of 7%, HSU (2X daily bull) would land our investor at 1,114$. This would be his new base of calculation for next day’s index fall of 10%, which would pull him down at $912. Next day’s 5% market hike, totalling a cumulative index gain of 1%, would pull him up at $1,003 - not at $1,010! After 25 days, when you add and subtract a string of incremental gains and losses, you end up with a total loss of 19%, even if the market has come back full circle to 100. With HSU, the loss is 40.7%.
That’s why Horizons’ Betapro are recommended only for the short-haul. The long haul can play tricks with an investor’s expectations.
If we return to Jeremy Kher, his new base with HUV, as he well knows, is $3,000, not $6,000. That means that the underlying index (S&P 500 VIX Short-Term Futures Index - SPVXSPIT) must register a hike of 100% for him to recover his starting capital. It is not impossible, but that index has registered such a gain only in 2011, shooting up from 9,208 on July 12 to 23,578 on October 3. Maybe a massive market meltdown could cause HUV to jump by 300%, 400% or even 500%, and Kehr could then pocket something like a $10,000 profit from his $3,000. But he would not pull in $100,000, and certainly not $3 million. “In investing, there’s no free lunch,” Noble reminds us.
Morningstar’s director of investment research Ian Tam agrees. “Leveraged and inverse leveraged ETFs are in a word, volatile. Investing in any form of leveraged ETF amplifies your exposure to the underlying index or commodity price. There are very few investors that have the ability to time the market precisely enough to take advantage of the intended purpose of leveraged ETFs. For most retail investors, having a long-term outlook and investing conservatively remains as time-tested approach to reaching your financial goals,” he says.
